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Unformatted text preview: Chapter 8 Exchange and Comparative Advantage The Fundamental Principles of Exchange Any modern economy functions by an overwhelming number of trades, going on constantly, that are interrelated in a manner too complicated for any one individual to know or understand. The reason the whole system works is that while each individual knows the whole picture, particular individuals know a lot about their own tiny pieces of action. Each of them has the incentive to respond to changes in demand or supply, and the information about changes in others relative valuations that are conveyed by prices. The process of voluntary exchange works, on a scale and with detail that no one individual could possibly grasp, because individuals are free to express their preferences by demanding and supplying. This process generates prices that reflect these preferences, and provides incentive for others to respond. You engage in the process of exchange to get things you couldnt make, or that would be too hard to make, for yourself. An Efficient Exchange An efficient action is simply one for which the benefit exceeds the cost. The only step to extending this concept to an exchange or trade between two people is that each person has to consider the action giving up what Ive got for what this other guy is offering to be efficient. Gain from Trade the value the trade creates. Opposite Relative Valuation a necessary condition for voluntary change. An individual must gain from trade, valuing the good that he receives more than he values the good that he gives up. Every voluntary exchange benefits both parties; if it didnt, it would not take place. The only real source of our knowledge about others values and preferences is our observation of their actions. Our inability to know others values limits our ability to judge their exchanges. The Zero Sum Game or Objective-Value Fallacy A voluntary exchange makes each party better off, according to each traders values at the moment of trade, so some third individual who asserts that one or both of the traders is actually harmed must be relying on some standard other than the traders own judgments of value. Another improper standard for judging exchanges comes from the early stages of development of economic, but it still pops up in todays policy debates: the use of some concept of objective, rather than subjective, value....
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